This page is a collection of reflections, contemplations, thoughts; about life, about death, about people, about stock markets, about science, about scientists, about economy, about economists, about art, about artists, about books and authors...

Lucky
scratched his head. Looked around. Buried his head again in the
newspaper.

Looked
up again. Scratched his beard. Got up and hesitantly walked up to the lady
sitting on the far end right corner of the student lounge at the University.

She
looked up at the smartest guy in her executive education class. Lucky was a
successful software developer, who had made money through stock options that
his company gave him for performance. Gesturing him to take the chair opposite
her, she asked, "where are you lost?".

"Look
at this Professor Nicky", said Lucky, holding out the newspaper to her and
pointing at the article that he was reading.

Lucky:
I have some money as fixed deposit with my bank. It is giving me a return of
9.25 percent per annum. I know it is a very safe way to get returns. But I also
know that I am not maximizing my returns.

I may get more returns by taking some measured risk. I am a bachelor. I don't
need to send money home. I can afford to take some risk.

But
I don't know how to go about doing it. I am comfortable with programming, but
finance scares me. If you can help me understand this article and what is
modern portfolio theory, I might get over my fear and get started.

Nicky:
But you can go to an investment advisor!

Lucky:
Yes. But I don't want to. I have had a bad experience earlier when one of them
sold me a Unit Linked Investment Plan and I lost half of my invested money. I
later came to know that they get a hefty commission for selling some of the
products. So now I want to manage my investments on my own.

Nicky:
Well, once bitten twice shy. But not all investment advisors are bad. And now,
even the regulators are tightening the norms and making it safer for the
investors. Having said that, it is good that you want to manage your own
portfolio.

Let
me start from the beginning. Harry Markowitz, a Nobel laureate in economics,
introduced modern portfolio theory, a theory of finance that shows how risk
averse investors can construct portfolio to maximize expected return for a
given level of risk or to minimize risk for a given level of expected return.

He developed a simple framework, known as Mean-variance analysis, to analyze
the tradeoff between risk and return. To diversify the money in risky and risk
free assets, the first step is to find the optimal portfolio of risky assets
and the second step is to find the best combination of risk free asset and
optimal risky portfolio.

Lucky:
Now you are losing me. Risk free? Optimal risky portfolio?

Nupur:
Risk free assets are typically government issued short term bills or bonds.
Even though technically a fixed deposit is not risk free, you may consider it to
be close to risk free and continue to invest part of your money in fixed
deposits.

An
optimal risky portfolio is the market portfolio that provides maximum reward to
risk ratio; in other terms, the best combination of risky assets to be mixed
with safe assets to form the complete optimal portfolio. It can be
constructed by using a simple tool, Solver, in excel.

Lucky:
This article here says that there can be many minimum variance portfolios. If
that is the case, then which one should I choose?

Nicky:
On right track! To build an optimal risky portfolio, you need to maximize the
ratio of portfolio excess return to portfolio risk (standard deviation). This
ratio is known as the Sharpe Ratio. Once you find the portfolio which maximizes
the sharpe ratio, you can take that portfolio and invest part of your money in
it and the balance in a risk free asset.

Lucky:
How will I know how much to invest in each?

Nicky:
Ah that really depends upon how much risk you want to take. If you don't want
to take any risk, then your investment in risky portfolio will be zero percent.
But if you want to take some degree of risk, then you will invest say 30 or 40
percent of your money in the risky portfolio and balance in risk free assets.
It really depends upon your risk appetite.

Lucky:
Wow! And all this was told by Markowitz?

Nicky:
Yes. And he said many more things. But I guess this is enough for today. If you
want to know more about his and his theory, google his name and you will find
his originally published paper in the Journal of Finance in 1952.

I wish somebody had told me these
things when I was a student of Finance and while I was pursuing a PhD in
finance. I would have had a much better perspective of how and why things work
(or don't) the way they do! That's the first thought that came to my mind when
I read the first book of the trilogy tracing the evolution of money.

The second thought was that this
indigenous writer has written a book which is truly global in every sense. I
would take the liberty of placing him in the same league as a Niall Ferguson or
a Peter Bernstein, even though this is Vivek Kaul's first book.

We have heard of many college
dropouts who have gone on to become billionaires. Here is an example of a PhD
dropout, who it seems, is on the path to becoming a best-seller and an
authority on Money, its evolution, regulation and consequences.

'Easy Money' published by Sage
Publications takes us through the era when anything and everything was treated
as money in some or the other part of the world. From salt, to dried cod, cowry
shells to cattles and even slaves! Going as long back as the 12th century BC,
the book chalks the path for evolution of Gold as money by meticulously laying
forth the problems with alternatives and with having too many different money
types.

There are many interesting facts
throughout the book. It is fascinating to know that it was the Chinese who
first started using coins and that they "believed that money is meant to
roll around the world, and so it should be round". That the Chinese thought
of this in the 12th century BC is fascinating.

The depreciation of the currency,
or debasement, as it was known in the early centuries of the Christian era, and
practised by reducing the metal content in the coins, eerily echoes the concept
of printing more and more paper money to meet expenses, whereby 'money'
systematically loses value.

From barter to commodities as
money to paper money and then the evolution of the banking system, the journey
has lessons, as highlighted by the author in the conclusion, that all
regulators would do well to imbibe. Wildcat banking, free banking, bailing out
institutions existed centuries ago as well. But we have not learnt from history
and hence history repeats itself.

Kaul weaves together stories from
Egypt, China, India, Rome, USA and UK effortlessly, as also he does with Marco
Polo, Leonardo Fibonacci, Kublai Khan and the kings of the United Kingdom. He
explains the evolution of concepts like 'settlement' and 'bill of exchange'
through simple examples which make the book highly readable by even those who
do not have a basic degree in Finance, Accounting or Economics. The research is
thorough, language simple, stories fascinating. Everyone should read it.

Lucky was fascinated by the world of
stock markets. He had started investing the money made from his stock options
in equities a few months back.

The stocks were mostly selected based
on recommendations made by analysts on business news channels and the
newspapers.

Having lost 60 per cent of his
principal invested in a particular stock, he decided to take matters in his own
hands and learn about stock selection rather than depend on other. With
determination in his eyes, he knocked at Professor Nicky's door.

Nicky:
Good to see you Lucky. What brings you here?

Lucky:
Professor, I invested in a stock based on a recommendation, where the analyst
had used Price-To-Earnings (P/E) multiple. Before you accuse me of
blindly following the analysts, let me clarify that I did Google the term, did
my own analysis and then took a call to buy.

Nicky: The dark
side of valuation!

Lucky: What do
you mean?

Nicky:
Let me elaborate. The same multiple can be defined in different ways by
different people. Multiples can be misleading if you don’t know what
fundamentals drive each multiple and how the multiples are estimated.

Price to earning is not the only
multiple, though it is the most common. There are numerous multiples that
exist.

A multiple is simply a ratio of two
financial variables where enterprise value (measure of market value of all the
securities, viz. common stock, preference stock etc., of a company) and equity
market capitalisation (measure of market value of just common stock) are
used in numerator and various proxies for cash flow are used in denominator
such as Earnings Before Interest and Tax (EBIT), Earnings Before Interest Tax
Depreciation and Amortisation (EBITDA), Book Value, Sales, Employees, etc.

Lucky: But how
do we know which is the right multiple to use for a company? This analyst
always uses P/E Multiple.

Nicky: Keep in
mind that you can’t use these numerators interchangeably to define a multiple.
When the denominator is an enterprise level quantity such as EBIT, EBITDA,
Sales or employees, you should use the enterprise value in the numerator; and
when the denominator represents the shareholder level measure such as earnings
or book value of equity, you should use equity market value in the numerator.

Lucky: That
makes sense. But you did not answer my question. I am wondering whether any specific
multiple is used for a particular industry.

Nicky: Yes.
Some multiples make more sense for a certain industry than the other multiples.
For example, Price/Customer multiple can be used to value Cellular phone and
Internet companies while Price/unit multiple is suitable for soft drinks and
consumer product companies.

Price
to Earnings-growth ratio is generally used for growth Industries such as
technology, health and luxury goods.

Lucky: What
about Banks?

Nicky:
Price/Book value is the more appropriate multiple for valuing a Bank. However,
you must realise that when valuing a company using multiples, average multiple
of the rest of the companies in the industry or few select companies in the
industry is used.

If
the company which you are valuing, is very different from the other companies
in terms of size, geographical area of operation, growth prospects or
technology used, you may not get a meaningful value for the company using
multiples.

Lucky: What
about other valuation techniques?

Nicky: There
are many. Discounted cash flow method, dividend discount model, moat based
valuation, etc. The key is to figure out which model is best suited to the
company, which you want to value.

Lucky: Now, I
realise why you earlier said, “The Dark side of valuation”.

Nicky: Yes.
While valuation can be tricky, it is still better to invest with 'informed
ignorance' than total ignorance.

The Chutupalu valley, about 30
kilometers from Ranchi, capital of the state of Jharkhand, in India, reminds
you of the beauty of some of the hill stations in northern India. But apart
from the greenery, as far as the eye can see, an occasional rainbow and foggy
mornings, what characterizes the valley is the sight of hundreds of men pulling
their cycles uphill, with 10 to 20 sacks of coal loaded on each.

They buy the coal from various
mines or from illegal miners near the Ramgarh district, load the sacks of coal
on their cycles early in the morning and start the journey to Ranchi. The
journey, one way, is about 80 kilometers. The elevation is about 1000 ft. The
weights on each cycle could be anywhere between 150 to 200 kilograms.

They take one and a half days to
reach Ranchi, where they sell the coal to local restaurants and households and
make Rs 400-500. They return to Ramgarh on the evening of the third day, only
to start the three-day cycle starts once again the following day. Their
earnings are often less than the average minimum daily wage of Rs 155 per day
(2012-13) under the Mahatma Gandhi National Rural Employment Guarantee Act
(MNREGA), and in inhuman conditions.

Their bare, cracked feet,
blackened and wet (from sweat) vests, and blackened trousers pulled up above
the knees make you wonder about the motivation for undertaking such hardship.
Ask them and the answer is simple: “Pet ke liye”
for food.

That the benefits of MNREGA, the
flagship programme of the United Progressive Alliance government, does not
reach them is obvious. So may be the case with the Food Security Act as well
whenever it is rolled out in Jharkhand. That the state and the central
government don’t know about these ‘coal pullers’ is also not believable as they
are as much a part of the valley as the rocks and the trees.

There are no official statistics
on the number of people engaged in pulling coal in the region. While people have
been engaged in coal picking and selling them locally since the last 40 to 50
years, the numbers were small till about 15 years back. But they have been
steadily increasing. A rough estimate is that around 7,000 to 8,000 men are
involved in this activity in the Ramgarh district. Around 1,000-2000 of them
would be operating between Ramgarh-Ranchi, through the Chutupalu valley. There
has been no effort to either organise them or help them in any way.

They are often accused of
stealing coal. “This is not right,” one of them says. “We buy from some people.
Where they get it from, we do not know”.

Theft is a factor often
attributed to the shortage of coal in the country. Coal mines in India, mostly
in the central and eastern part of the country, are located in isolated hilly
terrain and tribal areas. These underdeveloped areas, low on socio-economic
development, are perfect setting for anti-social activities such as coal theft.

According to a report by
Infraline Energy Research, New Delhi, people in these areas, steal coal from
all possible avenues. They come in groups, outnumber the security personnel and
take coal from stockyards. They create huge bumps on the road to slow down open
trucks loaded with coals and loot away tons of coal. In another adventurous fashion,
they arrest railway sidings, stop trains and take away hundreds of sacks of
coal in a jiffy. These groups include men, women and children – on foot, on
bicycles and on bullock carts. These groups of looters, local unemployed
people, are controlled and supported by mafia in these areas. They steal 50-100
bags at one go and later sell it to the mafia for small sum of money who later
make big profits in black market. This is the way of life for thousands of
families in the state.

However, these coal pullers
vehemently deny such charges. They maintain that they have nothing to do with
the coal thieves or the mafia. A coal puller says, “We don’t want to do this.
We know that in three to four years we will permanently spoil our knees and
develop other severe ailments. If we stole, life would have been easier. But we
don’t steal.”

In a state which is known as the
coal capital of India, such a plight is an irony. On the one hand, billions are
being made by industrialists and politicians through just the allocation of the
coal blocks, and on the other are the hardships suffered by these coal cycle
pullers for a pittance. It is a shame.

Friday, November 1, 2013

The second part of the gold analysis was published in the beyondbrics blog of the Financial Times on October 31, 2013. Once again my comments were used in the article. Do read it by clicking on the link below: